Chapter 10 Multiple-Choice

10.43 In auditing for unrecorded long-term bonds payable, an audit team most likely will a. Perform analytical procedures on the bond premium and discount accounts. b. Examine documentation of assets purchased with bond proceeds for liens. c. Compare interest expense with the bond payable amount for reasonableness. d. Confirm the existence of individual bondholders at year-end.

The recorded interest expense should reconcile with the outstanding bonds payable. If interest expense appears excessive relative to the recorded bonds payable, unrecorded long-term liabilities may exist.

10.35 When independent stock transfer agents are not employed and the corporation issues its own stock and maintains stock records, canceled stock certificates should a. Be defaced to prevent reissuance and attached to their corresponding stubs. b. Not be defaced but be segregated from other stock certificates and retained in a canceled certificates file. c. Be destroyed to prevent fraudulent reissuance. d. Be defaced and sent to the secretary of state.

a. Be defaced to prevent reissuance and attached to their corresponding stubs. Stock certificates should be defaced but retained so the auditors can actually see the canceled certificate.

10.37 All corporate capital stock transactions should ultimately be traced to the a. Minutes of the meetings of the board of directors. b. Cash receipts journal. c. Cash disbursements journal. d. Numbered stock certificates.

a. Minutes of the meetings of the board of directors. Capital stock transactions are important by definition, and the directors should have approved all of them.

10.24 Loan covenants are used for which of the following reasons? a. To protect the lender from the borrower's substantially weakening of the latter's financial position. b. To protect the borrower from the lender's calling the loan early. c. To protect the auditors from false information by the borrower. d. To protect shareholders from management taking on too much debt.

a. To protect the lender from the borrower's substantially weakening of the latter's financial position. This is the purpose of covenants.

10.39 When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud most likely would be reduced if the a. Trust company has no direct contact with the entity employees responsible for maintaining investment accounting records. b. Securities are registered in the name of the trust company rather than the entity itself. c. Interest and dividend checks are mailed directly to an entity employee who is authorized to sell securities. d. The trust company places the securities in a bank safe deposit vault under the custodian's exclusive control.

a. Trust company has no direct contact with the entity employees responsible for maintaining investment accounting records. To conceal fraud related to marketable securities, collusion between those responsible for record keeping and custody would be required. The possibility of collusion is reduced if no direct contact between responsible parties exists.

10.28 Which of the following internal control activities would most likely justify reducing the assessment of the risks of material misstatement for long-term payable? a. The use of prenumbered purchase orders to prevent unrecorded notes. b. All direct borrowings on notes payable are authorized by the board of directors. c. Any use of assets for collateral on long-term notes payable are analyzed for criticality to operations. d. Proceeds from long-term notes payable are included in regular review of budgets to ensure adequacy of cash flow availability.

b. All direct borrowings on notes payable are authorized by the board of directors. Authorization by the board of directors is the most important control procedure for long-term notes payable.

10.42 An audit team testing long-term investments would ordinarily use analytical procedures to ascertain the reasonableness of the a. Existence of unrealized gains or losses. b. Completeness of recorded investment income. c. Classification as available-for-sale or trading securities. d. Valuation of trading securities.

b. Completeness of recorded investment income. The auditor may develop expectations regarding the completeness assertion for unrecorded investment income from stocks by using dividend records published by standard investment advisory services to recompute dividends received. Interest income from bond investments can be calculated from interest rates and payment dates noted on the certificates. Income from equity-based investments can be estimated from audited financial statements of the investees. Thus, applying an expected rate of return to the net investment amount may be an effective means of estimating total investment income.

10.47 Which of the following audit procedures would not likely be performed for audits of investments? a. Read board of directors' minutes for authorization of investment strategies. b. Confirm investments with registrar. c. Confirm investments with broker or trustee. d. Compare valuation to published market prices.

b. Confirm investments with registrar. The registrar would not have information related to the investor or market information.

10.44 An audit plan to examine long-term debt most likely would include steps that require a. Comparing the carrying amount of held-to-maturity securities with their year-end market values. b. Correlating interest expense recorded for the period with outstanding debt. c. Verifying the existence of the holders of the debt by direct confirmation. d. Inspecting the accounts payable subsidiary ledger for unrecorded long-term debt.

b. Correlating interest expense recorded for the period with outstanding debt. By reconciling interest expense with interest-bearing obligations, the auditor verifies the amount of outstanding liabilities. If interest expense is excessive in relation to the long-term debt, unrecorded interest-bearing obligations may be outstanding.

10.36 When a client company does not maintain its own capital stock records, the auditors should obtain written confirmation from the transfer agent and registrar concerning a. Restrictions on the payment of dividends. b. The number of shares issued and outstanding. c. Guarantees of preferred stock liquidation value. d. The number of shares subject to agreements to repurchase.

b. The number of shares issued and outstanding. The number of shares issued and outstanding is the record kept by the registrar/transfer agent.

10.49 ABC Company has 100 shares of IBM stock that it holds as an investment. The stock was purchased three years ago and has been in the client's safe deposit box along with other investment securities. During an inspection of securities held by the client, the auditor noted the 100 shares of IBM stock had a different CUSIP number than the number listed when purchased and the number verified during the previous audit. Which of the following would be the auditor's main concern about this discovery? a. The certificates in the safe deposit box were forgeries. b. There had been unauthorized buying and selling of investment securities. c. The securities may be misclassified on the balance sheet. d. ABC Company no longer owns the securities.

b. There had been unauthorized buying and selling of investment securities. The main concern is that someone sold the IBM securities (in order to use the cash) and repurchased the securities at a later date. This may have been done for personal use or for the company.

10.38 An audit plan for the examination of the retained earnings account should include a step that requires verification of the (choose two steps) a. Market value used to charge retained earnings to account for a 2-for-1 stock split. b. Approval of the adjustment to the beginning balance as a result of a write-down of account receivables. c. Authorization for both cash and stock dividends declared and paid. d. Gain or loss resulting from disposition of treasury shares.

c. Authorization for both cash and stock dividends declared and paid. d. Gain or loss resulting from disposition of treasury shares. These should be authorized by the board of directors. Gain or loss on treasury stock transactions should be audited.

10.25 A related party is a person or entity that a. Has a family tie to a management member. b. Does business with the company. c. Can exert significant influence over or be influenced by the company. d. Is a member of the company's management team or board of directors.

c. Can exert significant influence over or be influenced by the company.

10.48 Which of the following audit procedures would not likely be performed for audits of shareholders' equity? a. Read board of directors' minutes for authorization of equity transactions. b. Confirm outstanding common and preferred stock with stock registrar. c. Compare valuation of stock to published market prices. d. Obtain management representation about number of shares issued and outstanding.

c. Compare valuation of stock to published market prices. Market price is not important in valuing shareholder's equity.

10.23 Which of the following approaches is most suitable for auditing the finance and investment cycle? a. Perform extensive tests of controls and limit substantive procedures to analytical procedures b. Ignore internal controls and perform extensive substantive procedures c. Gain an understanding of internal controls and perform extensive substantive procedures d. Ignore internal controls and limit substantive procedures to analytical procedures

c. Gain an understanding of internal controls and perform extensive substantive procedures Controls must be reviewed (and tested for public companies); however, a substantive approach is preferred.

10.40 An audit team would most likely verify the interest earned on bond investments by a. Vouching the receipt and deposit of interest checks. b. Confirming the bond interest rate with the issuer of the bonds. c. Recomputing the interest earned on the basis of face amount, interest rate, and period held. d. Testing internal controls relevant to cash receipts.

c. Recomputing the interest earned on the basis of face amount, interest rate, and period held. The audit program for long-term investments includes making an independent computation of revenue (such as dividends and interest). For example, bond certificates contain information about interest rates, payment dates, issue date, and face amount that the auditor can use to recalculate bond interest earned, including amounts accrued but not collected, during the period the auditee has held the investment.

10.27 When the client holds a large amount of negotiable securities, auditors need to plan to guard against a. Unauthorized negotiation of the securities before they are counted. b. Unrecorded sales of securities after they are counted. c. Substitution of securities already counted for other securities that should be on hand but are not. d. Substitution of authentic securities with counterfeit securities.

c. Substitution of securities already counted for other securities that should be on hand but are not. The danger is that someone might move securities so the auditor counts them twice.

10.32 If the auditors discover that the carrying amount of a client's investments is overstated because of a loss in value that is other than a temporary decline in market value, they should insist that a. The approximate market value of the investments be shown in parentheses on the face of the balance sheet. b. The investments be classified as long term for balance-sheet purposes with full disclosure in the footnotes. c. The loss in value be recognized in the financial statements. d. The equity section of the balance sheet separately show a charge equal to the amount of the loss.

c. The loss in value be recognized in the financial statements. Losses on investment should be recorded in the accounts and shown in the financial statements. (Losses on trading securities in the income statement; loss on available-for-sale securities in the equity section.)

10.29 Which of the following assertions is most likely to have the highest risk of material misstatement for the goodwill account? a. Existence b. Completion c. Valuation d. Rights & Obligations

c. Valuation Because goodwill is not a separately identifiable asset, valuation is a level 3 fair value estimate and is generally considered a substantial risk in an audit.

10.34 The auditors should insist that a representative of the client be present during the inspection and count of securities to a. Lend authority to the auditors' directives. b. Detect forged securities. c. Coordinate the return of all securities to proper locations. d. Acknowledge the receipt of securities returned.

d. Acknowledge the receipt of securities returned. A client representative should be present to acknowledge return so the auditor will not be accused of theft.

10.45 Which of the following questions would auditors most likely include on an internal control questionnaire for notes payable? a. Are assets that collateralize notes payable critically needed for the entity's continued existence? b. Are two or more authorized signatures required on checks that repay notes payable? c. Are the proceeds from notes payable used to purchase noncurrent assets? d. Are direct borrowings on notes payable authorized by the board of directors?

d. Are direct borrowings on notes payable authorized by the board of directors? Control is enhanced when different persons or departments authorize, record, and maintain custody of assets for a class of transactions. Authorization of notes payable transactions is best done by the board of directors.

10.30 In connection with the audit of an issue of long-term bonds payable, the audit team should a. Determine whether bondholders are persons other than owners, directors, or officers of the company issuing the bond. b. Calculate the effective interest rate to see whether it is substantially the same as the rates charged for similar issues. c. Decide whether the bond issue was made without violating state or local laws or regulations. d. Ascertain that the client has obtained the opinion of counsel on the legality of the issue.

d. Ascertain that the client has obtained the opinion of counsel on the legality of the issue. Among the choices available, obtaining an opinion from legal counsel is the best response. The legality of a bond issue is important although not the only important thing.

10.46 An audit team's purpose in reviewing the documentation concerning the renewal of a note payable shortly after the balance-sheet date most likely is to obtain evidence concerning management's assertions about a. Existence. b. Valuation. c. Completeness. d. Classification.

d. Classification. vents such as the renewal of the note payable do not require adjustment of the financial statements but may require disclosure. Accordingly, the auditor should determine that the renewal had essentially the same terms and conditions as the recorded debt at year-end. A significant change may affect the presentation of notes payable such as a reclassification from short term to long term.

10.26 Jones was engaged to examine the financial statements of Gamma Corporation for the year ended June 30. Having completed an examination of the investment securities, which of the following is the best method of verifying the accuracy of recorded dividend income? a. Tracing recorded dividend income to cash receipts records and validated deposit slips. b. Performing analytical procedures and statistical sampling. c. Comparing recorded dividends with amounts appearing on federal information Form 1099. d. Comparing recorded dividends with a standard financial reporting service's record of dividends.

d. Comparing recorded dividends with a standard financial reporting service's record of dividends. Independent evidence from an outside dividend reporting service is the best evidence for existence, completeness, and valuation.

10.33 The primary reason for preparing a reconciliation between interest-bearing obligations outstanding during the year and interest expense in the financial statements is to a. Evaluate internal control over securities. b. Determine the validity of prepaid interest expense. c. Ascertain the reasonableness of imputed interest. d. Detect unrecorded liabilities.

d. Detect unrecorded liabilities. "Detect unrecorded liabilities" is the best response, but remember that the procedure might be ineffective if the interest expense on an unrecorded liability is also unrecorded.

10.31 Which of the following is the most important audit consideration when examining the stockholders' equity section of a client's balance sheet? a. Changes in the capital stock account are verified by an independent stock transfer agent. b. Stock dividends and stock splits during the year under audit were approved by the stockholders. c. Stock dividends are capitalized at par or stated value on the dividend declaration date. d. Entries in the capital stock account can be traced to resolutions in the minutes of meetings of the board of directors.

d. Entries in the capital stock account can be traced to resolutions in the minutes of meetings of the board of directors. Capital stock transactions are important by definition, and the directors should have approved all of them.

10.41 A client has a large and active investment portfolio that is kept in a bank safe deposit box. If the auditors are unable to count securities at the balance sheet date, they most likely will a. Request the bank to confirm to the auditors the contents of the safe deposit box at the balance-sheet date. b. Examine supporting evidence for transactions occurring during the year. c. Count the securities at a subsequent date and confirm with the bank whether securities were added or removed since the balance-sheet date. d. Request the client to have the bank seal the safe deposit box until the auditors can count the securities at a subsequent date.

d. Request the client to have the bank seal the safe deposit box until the auditors can count the securities at a subsequent date. Securities should be inspected simultaneously with the verification of cash and the count of other liquid assets to prevent transfers among asset categories for the purpose of concealing a shortage. If this procedure is not possible but the securities are kept by a custodian in a bank safe deposit box, the client may instruct the custodian that no one is to have access to the securities unless in the presence of the auditor. Thus, when finally inspecting the securities, the auditor may conclude that they represent what was on hand at the balance-sheet date.